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Economic Benefits of Integrated Risk Products

Lawrence A. BergerSwiss Re New Markets

CAS Financial Risk Management SeminarDenver, CO, April 12, 1999

Session: Innovative Approaches to Managing Financial Risk

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Integrated contracts combine several risk lines over several years into a product with common retention and coverage

Single Line vs. Integrated Program Design

Years

Traditional single line approach• Yearly renewals• Separate lines• Many providers• Cost intensive

Co

ve

rag

e

12

3

Integrated approach• Multi-year• Multi-line• One provider• Cost efficient

Years

12

3

Insu

ranc

e Li

ne 1

Insu

ranc

e Li

ne 2

Fina

ncia

l Lin

e 1

Fina

ncia

l Lin

e 2

Co

ve

rag

e

Insu

ranc

e Li

ne 1

Insu

ranc

e Li

ne 2

Fin a

ncia

l Lin

e 1

Fin

Line

2

3

Integrated coverage is a more efficient way to provide insurance capacity

One block of capacity is available to meet all losses.

Across lines of insurance

Across financial exposures

Across time

Unused capacity from one risk is available to fund losses from other risks.

Unused capacity from one year is available to fund losses from future years.

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Integrated coverage is a more efficient way to provide insurance capacity

Insuranceand

FinancialCapacity

InsuranceCapacity

IntegratedSolution

Single Lines

InsuranceLoss

FinancialLoss

FinancialCapacity

Loss Experience

Retention Retention Retention Retention Retention

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Integrated coverage is a more efficient way to provide insurance capacity

InsuranceLoss

FinancialLoss

InsuranceLoss

FinancialLoss

UnusedCapacity

NotCovered

UnusedCapacityIntegrated

Solution

SingleLines

6

Integrated contracts provide a superior coverage structure compared to single line contracts

Line 2

Line 1

Coverage with two single lines

50

50

Line 250 200

50

200

Line 1

Coverage with limits

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Integrated contracts provide a superior coverage structure compared to single line contracts

Line 2

Line 1

Line 2

Line 1

Integrated coverage enables a superior risk management technology:

• New full coverage for large combined losses regardless of their composition (A)

• Elimination of coverage for low losses in one risk line if the loss in the other risk line is relatively small (B)

• Covers low frequency, high severity events. Insured retains high frequency, low severity risks.

Integrated Coverage

B

B

A

A

50 200

50

200

100

400

100 400

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Cost Savings

Cost savings can range from 10-20% when the probability of losses in area A is considerably less than area B.

Alternatively, retention can be lowered and/or capacity can be increased to be comparable in cost to single line coverage.

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Quantifying the Benefits

How to include the higher expected retention?

Utility theory approach:

Expected utility is higher for the purchaser of an integrated cover than for the purchaser of an unbundled cover with the same cost.

10

DFA Analysis

Economic and

Asset Simulation

A

Liability &Business

Simulation

L

Optimization& Valuation

M

Measurable Financial

Risk

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A simulation model is used to project possible future economic and capital market conditions.

Interest rates, inflation, P/E ratios, GDP, currency strength, alternative yield curve factors

Asset class characteristics and parameters

500 - 1,000 or more stochastic (random) economic and capital market scenarios

Asset class total returns, broken down into income and capital appreciation

Key Inputs Key Outputs

Economic andCapital Market

SimulationModel

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Interest rates are simulated to capture year-to-year volatility and its impact on financial results...

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

12/31/96 12/31/97 12/31/98 12/31/99 12/31/00 12/31/01

90-day T-bill

Rat

e

13

...to reflect the risk exposure of alternative investment strategies.

Bonds BondsCash 1-5 year 5-10 year Equities

Mean Standard Dev.

6.0% 6.7% 7.1% 11.0%1.5% 4.6% 9.5% 20.6%

-20

-10

0

10

20

30

40

50

60

Percentile

95th

75th50th

25th

5th

Average Annual Returns

To

tal

Ret

urn

(%

)

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Liabilities are simulated to create a picture of current and future premium, loss and expense cash flows.

Existing reserve data & characteristics

Business Plan assumptions (3-5 yrs)

500 - 10,000 stochastic liability scenarios

Distribution of existing reserve cash flows

Distribution of new business cash flows

Key Inputs Key Outputs

LiabilitySimulation

Model

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The asset and liability scenarios are put together to assess risk and reward opportunities.

Economic and asset scenarios

Liability and business scenarios

Financial data (statutory, GAAP, tax)

Objectives and constraints

Sensitivity testing

ALM efficient investment strategies (surplus risk & reward)

Stochastic financial statements

Risk Management Analysis

Strategic business applications

Key Inputs Key Outputs/Uses

Optimization& Valuation

System

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Statutory Surplus Risk Profile

240,000

290,000

340,000

390,000

440,000

490,000

540,000

590,000

Yr 1 Current Reins Yr 1 Agg Excess Yr 2 Current Reins Yr 2 Agg Excess Yr 3 Current Reins Yr 3 Agg Excess

5% to 25% 5% to 25% 25% to 50% 50% to 75% 75% to 95%

Years 1 - 3Statutory Surplus

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GAAP Income Risk Profile

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

Yr 1 Current Reins Yr 1 Agg Excess Yr 2 Current Reins Yr 2 Agg Excess Yr 3 Current Reins Yr 3 Agg Excess

5% to 25% 25% to 50% 50% to 75% 75% to 95%

Years 1 - 3GAAP Income

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Equities

Interest Rates

Foreign Exchange

Corporate Bond Defaults

Commodities

Capital Markets Coverages

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Equity Market Risk

Company 1 is a mutual company with a large position in equities due to the runup in equity values.Management is concerned about future declines in value.

Solution: Combine reinsurance protection with protection against declines in the S&P 500. Provide aggregate excess of loss where retention is reduced with declines in S&P.Protects against impact of equity market declines on income and surplus.

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Equity Market Risk

Provides cost savings for a company that buys reinsurance and equity market protection separately.

Provides expanded protection at additional cost for a company that does not currently hedge its equity position.

Alternatively, an Integrated Collar approach can be used to provide equity market protection at no additional cost (see below).

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Interest Rate Risk

Company 2 is a stock company with a large position in corporate and government bonds. Management is concerned about the potential impact of increases in interest rates on net worth.

Solution: Combine reinsurance protection with protection against increases in interest rates. Provide aggregate excess of loss where retention is reduced with increases in an interest rate index.

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Combined Capital Markets Coverage

If Company 2 is also concerned about equity market declines, retention can be reduced with an increase in interest rates and/or a decline in the S&P 500 in one combined cover.

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Corporate Bond Defaults

Company 3 has a large position in corporate bonds. Management is concerned about the potential impact of corporate bond defaults on surplus.

Solution: Combine reinsurance protection with protection against corporate bond defaults. Aggregate excess of loss is extended to include losses on corporate bonds as insurable coverage.

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Combined Capital Markets Coverage

A company with exposures to equity markets, interest rates and corporate bond defaults can include all of these risks in an integrated cover together with traditional reinsurance.

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Aggregate Excess of Loss where retention goes up or down depending on performance of capital markets exposures.

Example: Retention moves up when S&P goes up by more than 15% in one year. Retention moves down when S&P goes down by more than 5% in one year.

Integrated Collar

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Can be designed to add no additional cost to the aggregate cover.

Retention can also move with interest rates, or can move with the S&P and/or interest rates in a combined cover

Integrated Collar